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The Interest Rate: A Rough Beginner’s Guide

25 Jul 2017

Last week, the South African Reserve Bank announced a ‘surprise cut’ in interest rates. It dropped the Repo rate by 25 basis points (that is: the Repo Rate was 7.00%, and it’s now 6.75%). And the prime interest rate (which is usually the reference rate for your loans and credit) adjusted by the same amount.

So the question is: how did this happen? Also, how does it change anything?

Murky Monetary Policy

Most of us (myself included) just blithely accept that the Reserve Bank’s adjustment to the base interest rate will somehow affect us. It has to. I mean: credit cards and stuff.

There’s this blurred mental image of loose linkages: something about interest rates and banks and the National Credit Act. Maybe some outrage over furniture dealers and their absurdly high hire purchase contracts. Just a general fuzz of words and terms and newspaper headlines. But somehow *waves hands around in front of face* it’s all connected.

But haze is not good.

So let’s talk.

Interest Rate Mechanics: how does the SARB changing the Repo make FNB change Prime?

It’s a curious thing. Reserve Banks do not command commercial banks to change interest rates – it just sort of magically happens.

It works as follows:

As you probably know, banks are in the business of accepting deposits and making loans. So let’s start this story with a bank deposit.

When you deposit some money at the bank, most of it will be taken and invested by the bank in short-term government securities (temporarily).

When the bank decides to lend some of your money out, it will sell a few securities, and lend the money on.

And not necessarily in that order. The bank will have a stock of reserves (in the form of government securities) held at the Reserve Bank – and it will buy and sell these as necessary.

There is also a set limit below which those reserves cannot fall (the reserve requirement).

It’s a bit of a simplification, but that’s more or less the deal.

Who does the bank buy and sell government securities from?

Answer – the Reserve Bank.

And at what price?

The price is calculated based on the Reserve Bank’s set Repurchase Agreement Rate (that is: the Repo rate).

The Repo Rate is essentially a discount rate on short-term securities (eg. if the security entitles the holder to R100 to be repaid in 3 month’s time, then a Repo Rate of 5% will mean that the Reserve Bank will buy that government security for R98.75* from the commercial bank).*R100 × [1 – (5% × 3 months/12 months)]

So all of a bank’s activities are approximately-linked to the Repo Rate*. And the banks make money by offering us deposit rates that are less than what they earn from the Reserve Bank; and by lending us money at rates that are higher than what they pay to the Reserve Bank:*the banks also borrow money themselves through bond raisings and that kind of thing – so the link between banks and the Repo rate is not as strong as it used to be.

But that alone does not explain why Prime shifts with the Repo rate. Obviously, if the rate of Repo rate goes up, then the banks are really quick to increase lending rates (otherwise, they’d lose money).

But why increase the rate that they offer on deposits?

Competition, but mostly convention

One potential answer is simply “competition”. When the Reserve Bank raises the Repo rate, every bank can afford to offer better deposit rates without being worse off. If, say, FNB doesn’t follow suit, and keeps deposit rates low, then it will start to lose customers to the other banks. And because losing depositors is terrible news for banks (it means less loans, which means less money), everyone just takes it on the chin before the fight begins.

The reality is that the ‘prime’ interest rate is a convention that was set in the early days of the Reserve Bank.

My guess is that the bankers got together with the SARB and decided that such-and-such spread above the repo rate would be ‘prime’. And any newcomer bank would just have to accept the status quo.

Periodically, the spread gets a bit ‘renegotiated’ by market forces. The last adjustment was in 2001, where the prime-repo spread settled at 350 basis points. Meaning that the prime interest rate is always 3.50% above the repo rate.

And this Prime “plus a factor” situation on my mortgage?

Prime acts like a benchmark. In theory, it’s the rate at which a bank will lend to a “prime” borrower, being someone with a good credit history, good job, and good collateral. In practice, it’s just a convenient reference point that’s been set by convention.

If you have a good credit history, a reasonable income and some collateral, then maybe you’d have a low factor (like +0.5% or something). And if you’re a super-awesome borrower (notably – bank employees, because the bank controls their paycheck and collection is real easy), you could probably get an interest rate that’s below prime (a negative factor).

If you’re a bit riskier, then your prime factor might get quite high. And then, eventually, you get the people whose financing is denied until they return with a reasonable credit history and a solid payslip.

It’s why we need credit cards. For the credit history.

And how does a change in the repo change the economy?

Here’s a picture from the Reserve Bank:

You might notice that a lot seems to hinge on the repurchase rate.

I have some questions about how effective this is:

When the economy is doing okay-ish, then a small change in interest rates might have quite a nice multiplier effect; but

When the economy is in crisis, then I can’t help but think interest rates are mostly irrelevant.

For evidence, I’d point to the last financial crisis, where near-zero interest rates seemed to have very little impact on the main economy.

But let me give you a metaphor:

Interest rate cuts are like bandaids.

If you’ve got a small cut, they’re useful.

If you’ve got a large cut, they can help – but you might need some stitches as well.

But if you have cancer, then what exactly are y0u planning to do with that bandaid?